ACG 2071

Module 3: Financial Statement Analysis

Basic Analytical Procedures

The basic financial statements provide much of the information users need
to make economic decisions about businesses.
In order to make decisions, we must analyze the financial statements.
Horizontal Analysis
o Percentage analysis of increases and decreases in related items in
comparative financial statements.
o Comparing of income statements for two years
o Comparing of balance sheets for two years

Example: Below is a excerpt from a comparative balance for Diaz Company.

2006 2005 Amount Percent

Assets
Current assets $550,000 $533,000 $17,000 3.2%
Fixed assets $445,000 $470,000 -$25,000 -5.4%
Total assets $995,000 $1,003,000 -$8,000 -2.2%
Liabilities
Current liabilities $200,000 $150,000 $50,000 25%
Long term liabilities $100,000 $125,000 -$20,000 -20%
Total liabilities $300,000 $275,000 $30,000 5%
Equity
Common stock $500,000 $428,000 $72,000 17%
Retained earinings 195,000 $300,000 $105,000 -35%
Total equity $695,000 $728,000 $33,000 -18%
Total liab & equity $995,000 $1,003,000 - $8,000 -2.2%

More information is needed to evaluate the decreases and increases above. But
we can see a significant change in liabilities but not in assets.

Same can be done for an income statement

Vertical Analysis
 ACG 2071
Module 3: Financial Statement Analysis
o A percentage analysis may also be used to show the relationship of
each component to the total within a single statement.
o Balance sheet
 Each asset is shown as percentage of total assets
 Each liability as percentage of total liabilities
o Income statement
 Each item is shown as percentage of net sales.
o Common size statements
 Can be used to compare to companies in the same industry

Solvency Analysis
Solvency is the ability of a company to pay its debts.
Profitability is the ability of a business to earn income.
o They are interrelated.
Solvency analysis focuses on the ability of a business to pay or otherwise
satisfy its current and noncurrent liabilities.
o Assessed by examining balance sheet relationships
o Major analyses are:
 Current position analysis
 Accounts receivable analysis
 Inventory analysis
 The ratio of fixed assets to long-term liabilities
 The number of times interest charges are earned.

Example: Suppose the following balance sheet information is available for two
companies:

Company A Company B
2006 2005 2006 2005
Current Assets
Cash $ 78,000.00 $ 82,500.00 $ 160,000.00 $ 112,500.00
Marketable Securities $ 52,000.00 $ 60,000.00 $ 85,000.00 $ 26,000.00
Accounts receivable $ 106,000.00 $ 152,000.00 $ 208,000.00 $ 172,000.00
Inventories $ 218,000.00 $ 260,000.00 $ 350,000.00 $ 312,500.00
Prepaid Expenses $ 6,000.00 $ 4,200.00 $ 10,000.00 $ 10,000.00
Total current assets $ 460,000.00 $ 558,700.00 $ 813,000.00 $ 633,000.00
Current liabilities $ 320,000.00 $ 480,000.00 $ 705,000.00 $ 375,000.00

Current Position Analysis

o Measures to assess a business’s ability to pay its current liabilities
 ACG 2071
Module 3: Financial Statement Analysis
o Special interest to short-term creditors
o Working Capital
 Current assets minus current liabilities
 Used in evaluating a company’s ability to meet currently
maturing debts.
o Current Ratio
 Working capital ratio or banker’s ratio
 Computed by dividing current assets by current liabilities.

Example: Using the example above compute the working capital and the current
ratio.

Company A Company B
2006 2005 2006 2005
Working Capital
Current assets -
current liabilities $ 140,000.00 $ 78,700.00 $ 108,000.00 $ 258,000.00

Current ratio 460000/320000 558700/480000 813000/705000 633000/375000

current assets/current
liabilities 1.4 1.2 1.2 1.7

The companies in the above example, both have positive working capital and
current ratios of over 1. Yet the ability of each company to pay its debts is
significantly different.

Monies tied up in inventory and receivables are harder to convert to cash than
cash or securities. Therefore, the time factor may make the companies less
solvent.

o Quick Ratio:
 A ratio that measures the instant debt paying ability of a
company
 Also called the acid test ratio
 Ratio of quick assets to total current liabilities
 Quick assets are cash and other current assets that can
be quickly converted to cash such as marketable
securities and accounts receivables.

ACG 2071
Module 3: Financial Statement Analysis
Company Company
A B
2006 2005 2006 2005
Current Assets
$ $ $ $
Cash 78,000.00 82,500.00 160,000.00 112,500.00
$ $ $ $
Marketable Securities 52,000.00 60,000.00 85,000.00 26,000.00
$ $ $ $
Accounts receivable 106,000.00 152,000.00 208,000.00 172,000.00
$ $ $ $
Total Quick Assets 236,000.00 294,500.00 453,000.00 310,500.00
Total current $ $ $ $
liabilities 320,000.00 480,000.00 705,000.00 375,000.00

Quick ratio 236000/320000 294500/480000 453000/705000 31500/375000

quick assets/ current
liabilities 0.7 0.6 0.6 0.8

o Accounts receivable analysis

 The size and makeup of accounts receivable change constantly
during business operations
 Companies desire to collect receivables as promptly as possible
 Cash collected from receivables improve solvency
 Accounts receivable turnover
 Relationship between sales and accounts receivable
 Computed by net sales divided by average net accounts
receivable
 Average of accounts receivable
o Beginning balance plus ending balance divided by
2
 Higher the turnover the better.

Company A
2006
Net sales $ 1,500,000.00
Accounts receivable
Beginning of year $ 152,000.00
End of Year $ 76,000.00
2005
$ 998,000.00
$ 208,000.00
$ 152,000.00

Average Accounts Receivable (152000+76000)/2 (152000+208000)/2

$ 114,000.00 $ 180,000.00
Accounts receivable turnover 1500000/114000 998000/180000

13.2 5.5
 Number of days sales in receivables
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Module 3: Financial Statement Analysis
 Ratio is computed by dividing the average accounts
receivable by the average daily sales.
 Average daily sales is net sales divided by 365 days
 Lower the ratio the better

Company A
2006 2005
Net sales $ 1,500,000.00 $ 998,000.00
Accounts receivable
Beginning of year $ 152,000.00 $ 208,000.00
End of Year $ 76,000.00 $ 152,000.00
Average Accounts
Receivable (152000+76000)/2 (152000+208000)/2
$ 114,000.00 $ 180,000.00
Average daily sales 1500000/365 998000/365
$ 4,109.59 $ 2,734.25
Number of days sales in
receivables 114000/4109.59 180000/2734.25
27.7 65.8

o Inventory Analysis
 Inventory has to be managed carefully
 Too little inventory can cause customers to seek the
product from another supplier
 Too much inventory can increase storage costs,
insurance, and obsolescence.

 Inventory Turnover
o Relationship between the volume of goods sold
and inventory
o Computed by cost of goods sold divided by
average inventory
o Average inventory is beginning inventory plus
ending inventory divided by 2
o Higher the ratio the better

Company A
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Module 3: Financial Statement Analysis
2006 2005
Cost of goods sold $ 765,000.00 $ 820,000.00
Inventories
Beginning of year $ 312,000.00 $ 423,000.00
End of year $ 189,000.00 $ 312,000.00
Average inventory (312000+189000)/2 (312000+423000)/2
$ 250,500.00 $ 367,500.00
Inventory Turnover 765000/250500 820000/367500
3.1 2.2

 Number of days’ sales in inventory

 Relationship between cost of goods sold and inventory
 Computed by dividing the average inventory by the
average daily cost of goods sold ( COGS/365 days)
 Rough measure of the length of time it takes to acquire,
sell, and replace inventory
 Lower the ratio the better

Company A
2006 2005
Cost of goods sold $ 765,000.00 $ 820,000.00
Inventories
Beginning of year $ 312,000.00 $ 423,000.00
End of year $ 189,000.00 $ 312,000.00
Average inventory (312000+189000)/2 (312000+423000)/2
$ 250,500.00 $ 367,500.00
Average COGS 765000/365 820000/365
2,095.9 2,246.6
Number of days sales
in inventory 250500/2095.9 367500/2246.6
119.5 163.6

o Ratio of fixed assets to long-term liabilities

ACG 2071
Module 3: Financial Statement Analysis
 Indicates the margin of safety of the noteholders or bondholders
 Indicates the ability of the business to borrow additional funds
on a long-term basis.
 Higher the better

Company A
2006 2005
Fixed assets (net) $ 350,000.00 $ 480,000.00
Long-term liabilities $ 175,000.00 $ 210,000.00
Ratio of fixed assets
to long-term
liabilities 2.0 2.3

o Ratio of liabilities to stockholder’s equity

 Claims against the total assets of a business are divided into
two groups
 Claims of creditors
 Claims of owners
 the relationship between the total claims of the creditors and
owners
 solvency measure that indicates the margin of safety for
creditors
 indicates the ability of the business to withstand adverse
business conditions when the claims of creditors are large in
relation to the equity of the stockholders, there are usually
significant interest payments.
 If earnings decline to the point that company is unable to
meet interest payments, creditors may take over the
business.
 lower the better

Company A
2006 2005
Total liabilities $ 425,000.00 $ 375,000.00
Total stockholder's Equity $ 680,000.00 $ 503,000.00
Ratio of fixed assets to long-
term liabilities 0.6 0.7

o Number of times interest charges earned

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Module 3: Financial Statement Analysis
 Called the fixed charge coverage ratio
 The relative risk of the debtholders is normally measured
 Higher the ratio, the lower the risk that interest payments will not
be made if earnings decrease.
 Indicates general financial strength of the business

Company A
2006 2005
Income before taxes $ 150,000.00 $ 145,500.00
Add interest expense $ 4,500.00 $ 6,300.00
Amount available to meet
interest charges 154,500.0 151,800.0
Number of times interest
charges earned 154500/4500 151800/6300
34.3 24.1

Profitability Analysis
o The ability of a business to earn profits depends of the effectiveness
and efficiency of its operations as well as the resources available to it.
o Focuses primarily on the relationship between operating results as
reported in the income statement and resources available to the
business as reported in the balance sheet
o Major analysis used
 Ratio of net sales to assets
 Rate earned on total assets
 Rate earned on stockholder’s equity
 Rate earned on common stockholder’s equity
 Earnings per share on common stock
 Price-earning ratio
 Dividends per share
 Dividend yield

o Ratio of net sales to assets

 Is a profitability measure that shows how effectively a firm
utilizes its assets
 Higher the ratio is better
 Computed by dividing net sales by average total assets
(beginning total assets + ending total assets)/2

Company A
2006 2005
ACG 2071
Module 3: Financial Statement Analysis
Net sales $ 765,000.00 $ 820,000.00
Total assets
Beginning of year $ 980,000.00 $ 800,000.00
End of year $ 1,020,000.00 $ 980,000.00
Average Total Assets (980000+1020000)/2 (980000+800000)/2
$ 1,000,000.00 $ 890,000.00

Ratio of net sales to total assets 765000/1000000 820000/890000

0.8 0.9

o Rate earned on total assets

 Measures the profitability of total assets without considering
how the assets are financed.
 Higher the ratio is better
 Computed by adding interest expense to net income and then
dividing by average total assets

Company A
2006
Net income $ 165,000.00
Plus interest expense $ 6,000.00
TOTAL $ 171,000.00
Total assets
Beginning of year $ 980,000.00
End of year $ 1,020,000.00
Average Total Assets (980000+1020000)/2
$ 1,000,000.00
Rate earned on total
assets 171000/1000000
0.2
2005
$ 250,000.00
$ 19,000.00
$ 269,000.00
$ 800,000.00
$ 980,000.00
(980000+800000)/2
$ 890,000.00
269000/890000
0.3

o Rate earned on stockholder’s equity

 ACG 2071
Module 3: Financial Statement Analysis
 The measures emphasizes the rate of income earned on the
amount invested by the stockholders.
 Higher the ratio is better
 Computed by net income divided by average stockholder’s
equity
 The rate earned by a business on the equity of its stockholders
is usually higher than the rate earned on total assets.
 Occurs when the amount earned on assets acquired with
creditors’ funds is more than the interest paid to creditors
 The difference in the rate on stockholder’s equity and the
rate on total assets is called
o LEVERAGE

Company A
2006
Net income $ 165,000.00
Stockholder's equity
Beginning of year $ 1,250,000.00
End of year $ 1,500,000.00
Average Total Assets (1500000+1250000)/2
$ 1,375,000.00
Rate earned on
stockholder’s equity 171000/1000000
Rate earned on assets 12%
20%
LEVERAGE 8%
2005
$ 250,000.00
$ 800,000.00
$ 1,250,000.00
(1250000+800000)/2
$ 1,025,000.00
269000/890000
24%
30%
6%

o Rate earned on common stockholder’s equity

 Common stockholder’s have a residual claim on earnings
 This measure focuses only on the rate of profits earned on the
amount invested by the common stockholders
 Computed by subtracting the preferred dividends requirements
from the net income and dividing by the average common
stockholder’s equity. .
 Higher the ratio is better

Company A
2006 2005
ACG 2071
Module 3: Financial Statement Analysis
Net income $ 165,000.00 $ 250,000.00
Preferred dividends $ 9,000.00 $ 9,000.00
TOTAL $ 174,000.00 $ 259,000.00
Common Stockholder's
equity
Beginning of year $ 850,000.00 $ 600,000.00
End of year $ 950,000.00 $ 850,000.00
Average Total Assets (850000+950000)/2 (950000+600000)/2
$ 900,000.00 $ 725,000.00

Rate earned on common

stockholder's equity 174000/900000 259000/725000
19% 36%

o Earnings per share

 Normally reported in the income statement on corporate annual
reports
 Computed by dividing net income by the number of shares of
stock outstanding
 If preferred and common stock are outstanding, the net income
is reduced by the amount of preferred stock dividends.

Company A
2006 2005
Net income $ 165,000.00 $ 250,000.00
Preferred dividends $ 9,000.00 $ 9,000.00
TOTAL $ 174,000.00 $ 259,000.00
Shares of common stock 50000 45000
EPS 174000/50000 259000/45000
$ 3.48 $ 5.76

o Price-Earnings Ratio
 Indicator of a firm’s future earnings prospects
 Computed by dividing the market price per share of common
stock at a specific date by the annual earnings per share.

Company A
2006 2005
Market price per share $ 25.00 $ 17.50
Earnings per share $ 1.52 $ 1.36
Price earnings ratio 16.45 12.87

o Dividends per share and dividend yield

 ACG 2071
Module 3: Financial Statement Analysis
 Indicator of a firm’s future earnings prospects
 Computed by dividing the dividends per share by the market
price

Company A
2006 2005
Dividends per share $ 0.80 $ 1.20
Market price per share $ 25.00 $ 17.50
Dividend yield 0.03 0.07

Formula Use
Solvency Measures:
Working Capital Current Assets – Current Liabilities To indicate the ability to meet current
obligations
 ACG 2071
Module 3: Financial Statement Analysis
Current Ratio
Quick Ratio
Accounts receivable turnover
Number of days’ sales in receivables
Inventory Turnover
Number of Days’ Sales in Inventory
Ratio of Fixed Assets to Long-term
Liabilities
Ratio of liabilities to Stockholders’
Equity
Number of times interest charges
earned
Profitability Measures
Ratio of Net Sales to Assets
Rate earned on total assets
Rate earned on Stockholders’ Equity
Rate earned on Common
Stockholders’ Equity
Earnings per share on common
stock
Price Earnings Ratio
Dividends per share of common
stock
Dividend Yield
Current Assets
Current Liabilities
Quick Assets To indicate instant debt paying ability
Current Liabilities
Net sales To assess the efficiency in collecting
Average accounts receivable receivables and in the management of
credit
Average accounts receivable
Average daily sales
Cost of Goods Sold To assess the efficiency in the
Average Inventory management of inventory
Average inventory
Average Daily COGS
Fixed Assets (net) To indicate the margin of safety to
Long-term liabilities creditors
Total liabilities To indicate the margin of safety to
Total stockholders’ Equity creditors
Income before income tax + Interest Expense To assess the risk to debtholders in
Interest Expense terms of number of times interest
charges were earned
Net Sales To assess the effectiveness in the use
Average total assets of assets
Net income + Interest Expense To assess the profitability of assets
Average total assets
Net income To assess the profitability of the
Average Total stockholders’ equity investment by stockholders
Net income- Preferred dividends To assess the profitability of investment
Average Total common stockholders’ equity by common stockholders
Net income – Preferred dividends
Shares of common stock outstanding
Market price per share of common stock To indicate the future earnings
Earnings per share of common stock prospects based on the relationship
between market value of common
stock and earnings
Dividends To indicate the extent to which
Shares of common stock outstanding earnings are being distributed to
common stockholders
Dividends per share of common stock To indicate the rate of return to
Market price per share of common stock common stockholders in terms of
dividends